If you participate in a 401(k) plan, the good news is that you have more control over your retirement money. The bad news is that you have more control over your retirement money.
These ten rules may help.
A 401(k) enables you to build a better nest egg than anything else you can do on your own because of that tax-deferred growth. Saving money before it is included in your taxable income reduces your annual tax bill. In addition, the earnings can grow on a tax-deferred basis, meaning you can earn money on your earnings!
If your company offers a 401(k) plan, you need to be contributing, as soon as you can, and as much as you can. It is the first step in taking charge of your financial future.
In order to help you increase the size of your nest egg, as well as to encourage reluctant employees to save for retirement, many employers offer matching funds. The average employer offers a match of 50% of the amount you contribute up to 6% of your eligible salary. In the complex world of finances, we call this free money. If your employer is willing to give you free money, you need to take it!
The only catch is that you must contribute some of your own money in order to receive the company match. If your employer matches up to 6%, you should be contributing at least 6%. The goal is to capture the entire company match (and hopefully keep working there until you’re fully vested).
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Determine Your Investor Profile
Every investor is different and knowing yourself is the first step to allocating your investments appropriately. Before you can determine your asset allocation strategy, you must first be able to clearly define your goals.
Remember, 401(k) money is retirement money and everybody has different dreams about what their retirement will entail – traveling, boating, etc. Also, you may have some pre-retirement goals for which you need to save some money. Each goal may represent a separate pool of money and there are different investment options available to you to help fund each goal.
Second, determine the time horizon for retirement. Is it more than 10 years away? The longer you have until you need the money, the more heavily weighted you should be in stocks. You’ll have more time to recover any losses incurred during a market downturn.
The third consideration concerns how psychologically comfortable you are with those market downturns. Will you really be able to tolerate the inevitable ups and downs that the stock market delivers?
Understand Your Investment Options
Each asset class has different risk and return tendencies. For example, small capitalization stocks tend to be more volatile than large capitalization stocks. However, over long periods of time, they also tend to have higher returns. This is often referred to as a risk premium – you would expect to receive more reward for taking more risk.
The amount of risk a person should accept within their portfolio depends on several factors – when you need the money (not automatically dictated by your retirement age), how much money you have now and expect to need later, and what level of risk you’re willing to take.
Perhaps the most important factor is your time horizon – the more time you have, the more risk you can handle. History has shown us that risk tends to diminish over time. For example, from 1926 until 2001 the range of compound annual returns for small cap stocks over a one year holding period was from a high of 140% to a low of –60%. However, if you extend the holding period to 20 years, the range is from a high of 22% to a low of 5%.
How much risk you should take also depends on your goals. If you’re not late for work, why speed? In other words, if you are on target to meet your goals, why take risk that you don’t have to?
Finally, you should only take the level of risk that you’re comfortable with. If you find yourself unable to sleep at night every time your portfolio loses value, perhaps you shouldn’t be taking the risk you are.
All three factors should be considered together. Please note that past performance is no guarantee of future results.
Diversify Your Asset Allocation
Evaluate the risk and return tendencies of various investment options and how risk can be reduced and return can be increased when asset classes are combined in the right proportions. However, be aware that no investment plan or asset allocation strategy can eliminate the risk of fluctuating prices and uncertain returns. By all means, do not try to time the market. There are no proven strategies for market timing that have consistently beaten a well allocated portfolio.
Balance Your Need for Income and Growth
Rebalance and Reallocate
You may also need to consider other tactical moves if an investment suffers from style drift, there’s a change in management, or if similar investments with lower expenses become available. Take a disciplined approach to monitoring your investment portfolio.
Do Not Panic
Know Your Plan Features
Most plans allow for hardship withdrawals. There are several tax and penalty issues associated with hardship withdrawals, so make sure you read your plan documents carefully and seek professional guidance. If you use the option for hardship withdrawal, you may be suspended from the plan for a specified period.
The vesting schedule refers to the years of employment before the company match money becomes yours. Vesting schedules either are graded, meaning you get a percentage of the money in successive years of employment; or cliff, meaning you get all the money at once after no more than five years. Keep the vesting schedule in mind if you are thinking about quitting your job.
If the plan does not meet your investment needs, and it allows for in-service withdrawals, you can move some of the money into other vehicles, such as an Individual Retirement Account (IRA). An IRA gives you many options for investing your money, thereby enhancing your diversification abilities.
Early 401(k) plans had no provision for loans. Providers added most loan provisions as an incentive to encourage greater participation – participants would be more likely to save for retirement if they could access the money before they retired. This does not make loans an attractive feature! Many people believe (often erroneously) that if the interest rate on the 401(k) loan is less than they would have to pay elsewhere, the 401(k) loan is a good deal. That may be, but it does not take into consideration the real cost of the loan – the lost opportunity cost. The money in your plan cannot grow if it is not there! If the investments in your plan are growing by 12%, that is what borrowing from the plan costs you, plus growth on that growth. Another consideration needs to be the tax consequences of borrowing from your plan. While you do not pay any taxes on the money when you borrow it, you do pay the loan back with after-tax dollars. Then, when you begin to take withdrawals at retirement, you pay taxes on those dollars again – you are paying taxes twice. If you do some calculations, you may find that borrowing from your plan is an extremely expensive option. Borrow only if you must.
Many 401(k) plans offer the opportunity to buy the plan sponsor’s stock. Company stock can be a double-edged sword. On one hand, as a loyal employee who understands the business, you want to participate in the growth of the company by being a shareholder. On the other hand, it is risky to have too much of your portfolio in one stock, creating a non-diversified portfolio. Besides, do you really want the fortunes of one company to control your salary, benefits, pension and your 401(k)?